Monday, May 31, 2010


Additional Aspects of Incremental Cash Flow Analysis
  • Sunk costs

Sunk costs are outlays incurred in the past. They are the results of past decisions, and cannot be changed by future decisions. Since they do not influence future decisions, they are irrelevant costs. They are unavoidable and irrecoverable historical costs; they should simply be ignored in the investment analysis.

To illustrate, let us assume the example,

The soft drink company before deciding to introduce a new product, the company has conducted a market test. The results of the market test were found to be favorable. Should company include the market test costs in the evaluation of the new product? The answer is “no”. The costs of the market test have already been incurred and they are sunk costs; the decision to introduce a new product cannot affect them. They are, therefore, irrelevant to the decision of introducing new product.

Consider another example.

A company setup a plant for a cost of 200$ million to manufacture ball bearings. The project proved to be bad for the company, and it started accumulating losses. The total outflows to date is 300$ million. The company is thinking of abandoning the plant. Some executives consider it suicidal to abandon a plant on which 300$ million have already been spent. Others feel it equally unwise to continue with a plant, which has been incurring losses and officers no possibility of any satisfactory return on that money spent. The arguments of both the groups do not make sense. The 300$ million spent by the company is a sunk cost; therefore, it is irrelevant. It is also not correct to discard the plant since it is not earning a satisfactory return on a sunken investment. The company should take the decision to sell or not to sell the plant today in light of the future cash flows and return.

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